The somewhat complex world of proprietary trading and proprietary index levels can be easily understood by breaking it down into its constituent elements. Proprietary trading and proprietary indices are actually two separate phenomena, and although they can operate in conjunction with each other they can also function independently. That is, proprietary trading can be carried out without using a proprietary index, and a proprietary index can be accessed by those other than proprietary traders.

Proprietary trading

Proprietary trading is when a company such as a bank or an investment broker makes investments on its own behalf instead of on behalf of its customers or clients. That means it invests in the product in question for its own profit, rather than for the purpose of creating liquidity, making a market, or on the instructions of a client in return for a commission and/or fee.

Banks and finance firms often have a competitive advantage in the market and a proprietary trading desk at such a company may invest the company’s capital in financial transactions aimed at making a profit for the company or for the purpose of stockpiling valuable securities. The company then has the option of offering securities from its own inventory to its clients. This is particularly useful when the market is down or illiquid.

Proprietary trading can be carried out in any form of financial instrument or product, but derivatives are increasingly popular, while specialized proprietary trading firms use complex algorithms and predictive models to improve their success rate in what is an inherently risky business. It is this very risk that is capitalized on in order to increase profits.

In a big firm or bank the proprietary trading desk is separated from other trading desks both physically and by a number of information barriers, AKA Chinese walls. This is to prevent any conflict of interest. As a result, proprietary trading desks have the freedom to operate more or less anonymously.

Financial indices

In financial terms, an index is a statistical measure of change in a representative selection of data points, based on such factors as company performance, prices and productivity. An economic index can chart the health or otherwise of a company and by extension predict its future stock or share value. One of the most widely referred to economic indices is the Consumer Price Index, which tracks the cost of living in real terms based on the price of a representative selection of consumer goods and services.

Proprietary indices

Proprietary indexing, also known as self-indexing, refers to banks and investment firms creating their own indices for trading purposes rather than paying to use a standard, universal or benchmark index. With benchmark index providers often charging hundreds of thousands of dollars plus a percentage based on growth or assets, this is primarily a way to keep costs down. These savings can then be passed on to clients, although proprietary indices are only available to a limited number of clients, who are prepared to pay for the competitive advantage this gives them.

It’s possible to track proprietary index levels by subscribing to the Hammerstone Institutional Feed provided by the Hammerstone Group, which also includes professional stock analysis and discussion. Hammerstone subscribers can gain a competitive edge by leveraging the company’s considerable financial expertise and knowledge and staying one step ahead of market trends.

Smart beta trading

Smart beta refers to a type of proprietary index increasingly used in the exchange traded funds (ETF) market. Smart beta producers build proprietary indices based on a set of rules designed to give the best possible returns. Where a benchmark index generally weights stocks according to size, a proprietary index can price, and track products based on custom decided criteria. Designed in-house, they may also be tailored to the needs of individual clients. As such they fall somewhere between active fund management and traditional passive indices.

Factor analysis

Proprietary indices use data points intended to show why a stock is performing better or worse than the market and aims to take advantage of these market anomalies. That may involve establishing the underlying “real” value of a stock as opposed to its market value, and then buying those that seem undervalued on the market. Volatility, momentum and quality are other factors that may be considered.

A proprietary index is particularly valuable when trading in niche products or strategies that are not best served by the benchmark indices provided by Dow Jones, etc. These custom-tailored products give professional investors a sharp advantage, although they are not for the risk-averse.